In my quest for improvement, I have spent around 2 hours every day dedicated to learning for the last 10 years.
One of my favorite things to do is pick a very high achiever, study them diligently and then try to reverse engineer some insights that I can apply myself.
Lately, I have been studying Sam Zell.
Sam Zell caught my attention, when I read about the largest buyouts after Elon made the Twitter bid.
Zell sold one of his real estate companies to Blackstone for a whopping $39 billion, making this the largest leveraged buyout on record up to that date.
Today I want to share 3 topical principles and help you tap into a little bit of Sam Zell’s wisdom with over 50 years in Real Estate since he started in the 60’s.
Now obviously, things have changed a lot over the past 50 years. Even though history doesn't always repeat itself, the economic landscape we're seeing today with quickly rising interest rates and rising inflation actually looks very similar to what Zell experienced in the first 15 years of his own entrepreneurial career with record-high inflation at that time, which peaked in 1980 with the 10 year US Treasury yield getting 15% in 1981.
See below for relevant charts.
And the first core concept that I took away after studying him is directly related to this subject, and that is that in an inflationary environment, which is also seeing rising interest rates, borrowers with long-term fixed-rate tend to win out.
In an inflationary environment, which is also seeing rising interest rates, borrowers with long term fixed rate tend to win out.
Zell believes the real money in real estate came from borrowing long-term fixed-rate debt in an inflationary scenario that ultimately depreciated the value of a loan because your debt payments remain the same if the rate is fixed.
This is one of the biggest reasons real estate is often seen as an inflation hedge. It is largely due to the combination of leverage and increasing rents that are often tied directly to the changes in the consumer price index.
Simply means, as costs of goods rise with inflation, the rents also rise, but since the debt is fixed long term, the mortgage payments also remain fixed for that term.
See the CPI(Consumer price index) chart below.
All to say if your rents are increasing but your debt payment remains the same, your cash flow starts to increase.
For eg - This is a 6 unit I am buying at the moment. You can see my mortgage(line 58) is fixed for the next 5 years.
But with inflation, my rents and expenses will increase at the same rate, widening the margin of my cash flow as rent increases will apply to the topline and the expense increase just to the costs.
We don't know exactly what inflation or interest rate hikes are going to look like going forward. But it's pretty safe to say that interest rates have been at record lows up until the beginning of 2022. And inflation has been on a tear over the past year, and borrowers who took advantage of these rates by locking in long-term fixed rate debt are set up to see some pretty big spikes in cash flows and returns if both interest rates and inflation continue to run.
Replacement costs is the most reliable indictor of property values
Now, the second big thing that stood out to me was his emphasis on a property's replacement costs or the purchase price of the property relative to the cost to build a similar property in a similar location, which he credited as being the most reliable measure of value for properties in his portfolio.
Zell says that replacement costs matter more to him than rents, vacancy rates or economic growth because replacement costs directly dictate the pricing of future competition in the market.
And again, with the cost of materials seeing huge spikes over the last few years and inflation having a direct impact on the cost of labor, his thought process is also very relevant today when investors are looking at a new acquisition or at a property within their existing portfolio.
Replacement costs directly influence the economic principles of supply and demand and where rents and values within a market are likely to move as a result.
For example, if you're considering investing in a specific geographic market, and you know that properties are trading at a significant discount to replacement costs in the market, this can often mean that investors are going to be more likely to want to buy an existing asset rather than going through the headache and risk associated with taking on a new construction project, which keeps the risk of oversupply in the market low and keeps demand from the capital markets high if you ultimately wanted to sell the deal,
But let’s say if a developer did decide to build a new project in the market with significantly higher construction costs due to inflation, this is generally going to mean that the developer is going to have to charge significantly higher rents in order to make that deal work which can often insulate older properties from any major drops in occupancy or rents. Since these types of properties have now become the more cost-effective, affordable option in the area.
Put simply, if you could live in a property built in 2022 and pay less than you would to live in a property built-in 1980. All else being equal, you would probably choose the newer, nicer building, and paying more to live in the older outdated property just wouldn't make sense.
And when this plays out on a larger scale, this directly affects property values across an entire commercial real estate market.
The last major insight is related to acquisitions, but instead, this was related to Zell's philosophy around decision making on assets within your existing portfolio, which can be summed up really well in this statement by Zell,
“I have always believed that every day you choose to hold an asset, you are also choosing to buy it”
Zell talked about this in the context of the $39 billion sale of equity office to Blackstone and when he couldn't personally justify buying the portfolio himself at the price Blackstone was willing to pay. He knew that it was time to move forward with the deal.
Timing the market is an extremely difficult thing to do. But Zell has never been shy about getting out of the market when he feels like things might be overheated. And he clearly hasn't let himself get overly concerned about leaving money on the table if he's wrong, and prices continue to rise.
With valuations in proportion to operating incomes at sky-high levels currently, I think there's definitely something to be said about taking a hard look at your own portfolio and deciding whether or not you'd pay the price a buyer would pay in the market right now for each property that you will. And if that ends up not being the case, this could be a sign that you're not the only one feeling this way.
And if market conditions shift quickly as a result of things like a continued rise in interest rates, or economic slowdown like now, it will impact pricing and there might be a better and more efficient use of your capital out there and it might be worth considering taking your chips off the table.
I do want to caveat that it might be a subjective approach, and I personally will still look at the overall exit return like the IRR to inform my decision.
Bringing it home, it goes without saying that regardless of how successful one person has been, no one knows for sure what will happen in the future.
But I wanted to share the principles of someone who has possibly seen it all, including conditions that I found most applicable in today's real estate market, especially with many people confused about navigating the choppy waters.
I hope these thoughts can help you gain some insight from someone who has built a massive real estate portfolio over multiple real estate cycles.